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Sunday, March 4, 2012

Competition Demystified: Chapter 6

The author of the excellent book for beginners, Value Investing: From Graham to Buffett..., is back, this time with a book about how to understand and analyze competitive advantages. Investors interested in better understanding what gives a company a competitive advantage must give this book a read.

To further illustrate the effects of operating with and without competitive advantages, the authors further discuss the PC industry of the 1980s and 1990s. In the entire industry map of the PC industry, only the CPU and operating system segments had stable market share dominated by a few firms, suggesting these were the only ones with barriers to entry. Makers of peripherals (keyboards, mice etc.) and assemblers (IBM, Dell etc.) had no advantages.

The authors focus on two companies in particular, Compaq and Apple. As an early entrant into the premium business segment of the PC industry, Compaq did enjoy a competitive advantage for a time. Business users had a demand preference for the reliability and premium PCs Compaq offered, resulting in some economies of scale for the company as it built a lot of the peripheral devices (e.g. power supplies) itself.

As the PC market grew, however, these economies of scale disappeared, allowing low-cost firms the ability to best Compaq on price while matching them in quality. (Recall that a growing market erodes economy of scale advantages, as fixed costs become spread over a larger number of customers, reducing the advantage of the larger firms.) Eventually, Compaq was forced to abandon its production of devices that other, more-focused firms could provide.

After the ouster of Steve Jobs, Apple found itself involved in a lot of different components of the PC (peripherals, assembly, operating systems, application software) but none with competitive advantages. Even though Apple's operating system was likely superior to that of Microsoft in 1990, Microsoft enjoyed the scale that came with adopting the open standards that IBM set forth. At the same time, Apple used chips from Motorola, which again was at a disadvantage to the superior scale of Intel. Intel could spend much more on R&D, and yet still spend less on R&D per chip than its competitors, giving it a clear advantage in CPUs.

The authors discuss the strategic choices of these firms, arguing that both Compaq and Apple made decisions that suggested a lack of understanding of where their disadvantages lay.